Perspectives on where our world is heading from a vantage point in Denver, Colorado.

16 September 2008

The Lehman Brothers bankruptcy

The Lehman Brothers bankruptcy filing indicate that as of their May 31, 2008 financial statement that the firm has $639 billion of assets and $613 billion of debt. At that time the firm had about $110 billion in ordinary bonds, and about $17.6 billion in subordinated bonds. The composition of the other debts is hard to determine, in part, because of a bad cross reference in that part of the filing.

As of the last financial statement, accounts payable were about $71 billion, short term debt was $163 billion, other current liabilities were about $29 billion, and long term debt was about $350 billion.

As of the filing date, the listing of the top 30 outsider creditors of the firm mentioned $138 billion of ordinary bonds (managed by two bond trustees), $17 billion of subordinated bonds (managed by one of the two ordinary bond trustees), and about 3 billion in bank loans and letters of credit ranging in size from $463 million to $10 million from 23 different institutions (a few of whom appear to be related entities of each other). This leaves about $485 million of debts owed to creditors in amounts less than $10 million and insider debtors.

This would suggest that $71 billion+ is made up of trade credit in small amounts per creditor, while $414 billion is made up of financial creditors in amounts less than $10 million and insider debt, with insider debt probably making up the bulk of the debts, as investment banks don't generally take deposits from millions of households the way that commercial banks do.

There don't appear to be any significant (i.e. more than $10 million) secured creditors or trade creditors, although this might not include financial rights of setoff.

There are more details (and explanations for why better data isn't provided) in an Affidavit of the CFO, which is honestly rather dubious and unsatisfying. I find it very hard to believe that Lehman Brothers is incapable of providing much, much more information than it has to date with only modest effort. While it might not be able to provide ever single creditor in a matter of weeks (although with the joy of computers it is hard to see why it shouldn't, it has to do so every quarter anyway), it ought to be able to publicly account for more than a third of its outstanding debt. These folks are in the financial analysis business and live and die on their own ability to be highly leveraged without becoming insolvent.

Equity

The most recent financial statement listed the aggregate value of preferred stock at $7 billion (and did not include it as a debtor in the petition).

The aggregate redemption value of the preferred stock based upon the rights of each class of preferred stock, the number of preferred shares identified in the petition (presumably the number of authorized preferred shares in each class), and assuming that preferred stock dividends aren't grossly in arrears, is about $237 billion. This is calculated as follows:

Sanford Bernstein analyst Brad Hintz estimates that 55% of Lehman's balance sheet can be quickly liquidated, particularly such assets as receivables and short-term loans known as repurchase agreements. There are about $269 billion in securities that are "another story," Hintz wrote in a report released Monday. He estimates 27% of the $269 billion is in mortgages, 17% in derivatives, and 8% in real estate.

Analysis

The two primary bond trustees seem likely to be the dominant voice on behalf of creditors in this bankruptcy on the creditor's committee.

This could be a 100% payout liquidity failure bankruptcy, and failing that, could be one in which common stock shareholders, preferred stock shareholders, and perhaps subordinated debtors bear the brunt of the impact, while general creditors are held harmless or nearly so.

Indeed, if the company adopts a plan that holds harmless all preferred and general unsecured creditors, and all secured creditors, then only the holders of subordinated debt would have any right to object. Since all of the subordinated debt appears to be represented by a single bond trustee, this might mean that the plan could be confirmed in a one on one negotiation with the representative of that bank.

Equity and subordinated debt together are capable of absorbing a $43 billion loss between May 31, 2008 and the bankruptcy filing, and pre-bankruptcy loss estimates had been in the vicinity of $7 billion.

Barclays Bank is discussing buying the brokerage and investment banking operations including the headquarters out of bankruptcy for about $8 billion (presumably the usually highly profitable brick and mortar part of the operation which probably also counts for most accounts payable and accounts receivable), and assuming that this is a market value for that operation by some reasonable measure, the market losses that other creditors would have to bear would remain unchanges, but greater liquidity could speed up the payout.

The bankruptcy filing covers only Lehman’s holding company. Its brokerage and money-management units are not in Chapter 11 – employees still have their jobs, customers still execute transactions on accounts, and portfolio managers still manage mutual funds.

The relative independence of these subsidiaries from the bankruptcy process is what enables Barclays, the U.K.-bank that walked away from a Lehman rescue over the weekend, to consider purchasing part of Lehman.

Another interesting possibility would be a plan that allocated good, short term assets to outsider creditors as payment in full, while allocating securities of uncertain value, like the mortgage backed securities, to the insiders. Outsiders can't object if they get quick cash in exchange of the debts owed to them, so this plan could be imposed on them, leaving insiders with any windfalls resulting from market undervaluation of Lehman Brothers' complex financial assets.

The biggest overall risk is that the derivatives market, and in particular, the credit default market, will be screwed up by the freezing of the positions of a major market player, although recent bankruptcy law reforms are designed to minimize this impact.

Bottom line: Despite the drama, the class of people really taking a hit from this bankruptcy may be quite small.

10 comments:

This is a very prepared analysis, and is the only complete review of the actual numbers involved Lehman Brother's bankruptcy. As a substantial holder of Lehman Senior Notes and Series F Preferred Shares, I am very interested in the information, and thank you very much for your insights. Do you plan to provide any additional updates at this or any other site? And would you care to provide an estimated percentage return of investment that you believe preferred shareholders may recoup?

I update irregularly as new information of interest arises, typically in a new post, although I try to put a comment in my old post alerting readers to new information.

My personal prediction (caveat emptor, I don't know all the facts and certainly not potentially relevant details particular to you and I am not an investment advisor), is that the Senior Notes are going to come out fully paid, possibly with some compromise of interest due, probably within six months to a year and a half.

It is likely that the payout rate for all of the perferred stock will be identical (e.g. Class C is likely to get the same percentage payout as Class G), if there is any.

Normally, even insider subordinated debtors would have priority over preferred stock, so a paymjent

For the preferred stock to get anything, the loss, in the long term, in asset value from May 31, has to be on the order of $19 billion or less.

The firm's initial loss estimate of $7 billion is less than this amount, but the liquidity crisis has occurred because the investing public, made up of some very smart people, have been unwilling to fund Lehman Brothers, presumably because they believe that the $7 billion loss is a gross underestimate.

The primary concern is the long term assets, and in particular the roughly $70 billion of mortgage backed securities and $25 billion of deriviatives.

A $19 billion loss would likely come mostly from these two asset classes. A 20% haircut in each of these two asset classes would kill the common stock, but provide a full return to the preferred stock.

In reality, a more likely scenario would be to see perhaps a 10% haircut in the derivatives portfolio, and maybe a 23% haircut in the mortgage backed securities portfolio.

On a buy and hold basis, those seem like reasonable estimates of losses. The derivative portfolio is diversified and hedged and not the main focus of the current financial mayhem. The mortgage backed securities have actual real estate behind it (albeit with almost no homeowner equity and high default rates) so a total loss is extremely unlikely and a loss of 23% if close to having most borrowers on tne mortgages default and selling the houses in the market.

But, we have a market panic hear that demands quick resolution and nobody is interested in buying mortgage backed securities right now. Unless Fannie and Freddie buy a lot of the mortgage backed security portfolio, it is hard to see Lehman getting its long term value for these assets.

As a result, the preferred stock (who have much less say in the bankruptcy process than junior subordinated debt) are likely to be sacrificed in an effort to set prices that can liquidate undesirable assets more quickly.

Sacrificing preferred stock would allow the mortgage backed securities to be unloaded at about a 30% discount. while allowing a 20% discount on derivative positions, which are deep enough discounts that the big money smart players in the market might be willing to strike for those prices. So, I think that it is likely that return on preferred stock will be little or nothing, with the junior subordinated debt pushing very hard to prevent the losses from going further by taking ugly assets in exchange for a 100% payout.

Thanks much for taking the time for the detailed reply. While I realize that you are not an investment adviser, at this stage in the game it sometimes seems that the investment advisers' accumulated experience doesn't go too far towards addressing the current meltdown situation which the market is experiencing.

While your conclusion that the preferreds may be a total loss was not what I was hoping for, your analysis seems to be right on point. Hopefully, an alternative scenario to a complete loss on the preferreds would be a gradual unwinding of $70 billion of the MBSs, which could work out to also be in the interest of the Junior Subordinated Debt holders if the MBS haircut is anything greater than the 30%.

I also have previously arrived at a conclusion substantially similar to yours regarding the Senior Debt, and have been very surprised to see the notes trading at 20 cents on the dollar. There doesn't appear to me to be any possibility of this debt paying only 20 or 30 cents on the dollar (although Credit Insights has stated that a return of 60 - 80 cents is expected, I would believe that even those numbers are very low). Other than the uncertainty involved, any ideas why the Senior Debt is trading at such high discounts?

Finally, most of the notes I hold are long term notes due in 20+ years. Assuming the availability of funds, will those notes be paid at an additional discount to face value due to length to maturity, or is this not something typically factored in by the bankruptcy court?

Thanks again for the time spent in providing insight into the situation. I've evolved into the "family retirement funds manager" for several extended family members, and am looking to make an informed decision regarding the long-term prospects of the assets we hold.

The main reason for additional discounts is the "unknown unknowns" problem present in any bankruptcy. Simply put, if something as horrible as the mortgage based securities problem came up unexpectedly, what else is there that will hit us blindsided later?

Typically, long term notes have a principal amount at issuance, and an interest amount (imputed or express). They also typically accellerate upon default with a variety of conditions. Typically, their claim as general creditors would be based upon initial principal and accrued interest at the contractual rate (there is a certain amount of distinction between pre- and post- petition interest).

Sir,First of all I would like to apologize for my english.I am a spanish investor and holder of Lehman preferred Shares.Searching in internet I found this blog, and I congratulate you for this great blog.I think you analysis is quite good.I agree that the percentage of return in preferred shares will be nothing, but I like to believe that may be there is a chance of recover something.Your analysis is from sept 16, and I would like to ask you if after the sales to Barclays and Nomura you still have the same view?.Do you think that the bailout of 700 billion $ from U.S. goverment could help Lehman?If Lehman can sell to U.S. Goverment at a good price some of the subprime assets, in your opinion , is there any possibility that another Bank could buy a healthy lehman without bad assets, and also take its liabilities?Thank you and sorry form my english again.

Does anyone have an idea of how much Lehman Preferred shareholders will recoup on their shares. I read forums where common shareholders are expecting to get some money back per share. I thought the preferred shares must be paid off before anything goes to the common shareholders. I look forward to reading your input. Thanks

Andrew, Thank you for your insights in this matter. It's a complicated situation. How do you think holders of Structured Product notes (deemed senior unsecurred creditors of Lehman) fair in all of this?